Tax and Development: Competition for real investment and Profit Shifting

We develop a simple conceptual framework of asymmetric countries competing simultaneously for real investment and for profit shifting in the presence of tax haven. Our goal is to identify how this two-dimensional tax competition affects the performance of tax policy, including minimum tax rules. We define a developing country as one with either a narrower tax base or lower tax capacity. The developing country sets a lower tax rate, attracting FDI. We show that policies aimed at promoting FDI competition—such as reducing transaction costs, country risk, or market-entry barriers—do not necessarily benefit the developing country. There exists a critical threshold of real-investment competition beyond which intensified competition harms the developing country (and the developed country as well). We also identify a “tax capacity externality”: fighting profit shifting in the developed (high-tax) country always raises revenue in the developing country. Finally, we determine the level of the minimum tax that the developing country prefers. This preferred minimum tax increases with both the intensity of FDI competition and the developing country tax capacity.